ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – MUST A SINGLE MEMBER LLC TREAT WORKERS AS EMPLOYEES? – PART 2
By Robert S. Schriebman
This is Part 2 of a 3-Part series.
An LLC (Limited Liability Company) is treated as a corporate entity for IRS and EDD purposes. LLCs must treat common law employees as W2 wage earners with the exception of a single-member LLC. A single-member LLC files a 1040 individual tax return and is not required to pay employment and withholding taxes on its sole officer-member. It must, however, pay payroll taxes on all other employees. A multiple-member LLC must treat officer-members as W2 wage earners because corporate officers are by law statutory employees. What happens when a single-member-officer-employee disregards the law and treats all workers as independent contractors? The short answer is – big problems. The Cardiovascular Center, LLC v. Commissioner (U.S. Tax Court, TC Memo. 2023-64, May 18, 2023) case is the latest Tax Court decision clearly illustrating what not to do.
Cardiovascular Center, LLC Case – The Facts
Dr. K practices medicine as a single member LLC. His practice is in Arizona. Between 2010-2015 the LLC employed 5 workers all doing medical-related work. Apparently, Dr. K did not wish to get his hands dirty keeping those pesky books and records and paying employment and withholding taxes. He paid all of his workers with cashier’s checks. He took out no withholdings and he never filed a quarterly or annual payroll tax return. Each worker worked an average of 70 hours every two weeks. If they put in more time, they would be paid overtime. Each worker had to submit an “employee timesheet,” which had to be approved by the office manager who was Dr. K’s live-in partner, Ms. Smith. Dr. K did not give her a paycheck per se, but paid her personal expenses including mortgages, and interest on several real properties she owned.
Between 2010-2015, Dr. K never gave any worker either a W2 or a 1099. He treated all workers as independent contractors. All workers were subject to Dr. K’s supervision and reported to him. The workers were expected to follow office procedures that were set by Dr. K. None of the workers was able to realize a profit or loss because of their services. There were no formal employment contracts. The workers determined their own schedules where they were permitted to arrive and leave at any time. The workers were directed by Ms. Smith, the office manager, and Dr. K’s girlfriend. At her direction, the workers performed both “front office” and “back office” duties. Some of these duties were administrative and some were involved in patient care, such as scheduling appointments, checking blood pressure, pulse and weight, making entries into patient’s charts, and taking patients to patient rooms.
No quarterly 941 returns or annual FUTA 940 returns were ever filed with the IRS.
The IRS audited Dr. K and issued 6-years worth of quarterly and annual payroll tax assessments together with penalties and interest to the tune of over $325,000.
The Elements of Control
In Part 1, I discussed the important factor of control and explained the factors used by the Tax Court to determine if there was sufficient control by the service recipient to begin to change the relationship to one of employer-employee. The element of control, while very important, is only one factor. In the Cardiovascular Center, LLC case, the Tax Court set forth 7 new factors that must also go into the worker status equation.
The following are the 7 factors used by the Tax Court to determine whether those individuals working for Dr. K should have been treated as W2 wage earners. Not all of the factors have to be found to exist. As you will see below, a couple of the factors were found to be neutral and not applicable. Not all factors have the same weight. Once the factor of control is established, the rest of the factors, while important and necessary for analysis, count relatively little, but they do count to shift the relationship from that of independent contractor to employer-employee.
The following 7 key factors were used by the Tax court to determine whether Dr. K’s LLC had an employer-employee relationship with its staff as well as the office manager, Ms. Smith.
The Degree of Control Exercised by the Principal Over the Worker
The elements of control were discussed in Part 1. The degree of control over the worker is THE critical factor in determining whether an employment relationship exists. Dr. K and Ms. Smith clearly controlled the work environment. They established procedures the workers were expected to follow. Ms. Smith’s title was office manager, and she directed the daily work that was done by the staff. True, the staff could establish their own hours and were free to come and go as they pleased. But these factors were not significant enough to determine that those workers were autonomous. While control is only one of the 7 factors, it is the 600 lb. gorilla of all the other factors.
Which Party Invests in the Work Facilities Used by the Worker
Generally, a worker who provides his/her tools to complete the work would be considered an independent contractor. None of the workers used their own tools or supplies. Dr. K provided the staff with phones, computers, and medical supplies required to complete their job. This factor weighs in favor of an employment relationship and not one of independent contractor.
The Worker’s Opportunity for Profit or Loss
The workers were paid an established hourly rate. They were paid by cashier’s checks. There is no indication that there were any additional opportunities to seek profit or loss from the medical practice. While Ms. Smith did not receive a paycheck, Dr. K paid her personal expenses and the interest on several mortgages. This factor is in favor of an employment relationship.
Whether the Principle Can Discharge the Worker
The workers were free to quit at any time and there was no established process of termination. Many of the staff worked several years for Dr. K and the LLC. There were no written employment agreements (or independent contractor agreements). This factor is neutral in the determination as to whether an employment relationship existed.
Whether the Work is Part of the Principal’s Regular Business
Dr. K and the LLC ran a medical practice. The work performed by the staff was part of the regular business as a medical office. The staff performed mundane duties such as answering phones, scheduling appointments, faxing prescriptions, collecting payments, checking patients’ vitals, such as heart rate and blood pressure. This factor weighs in favor of an employment relationship.
The Permanency of the Relationship
Most of the staff stayed for several years, and most were employed between 2010-2015, the audit assessment periods. During these periods, they submitted timesheets indicating full-time work weeks. This indicates that the relationship between the workers, Dr. K and the LLC was not transitory. This factor weighs in favor of an employment relationship.
The Relationship the Parties Believed They Were Creating
Three workers were previously students that fulfilled part of their required training at Dr. K’s practice. During their training period these workers expressed an interest in working for Dr. K once their required hours were satisfied. This does not necessarily indicate that Dr. K and the workers believed they were creating an employment relationship. This factor is neutral.
While two of the factors were neutral, the majority of the factors, including the key factor of control, weighed heavily in favor of employment relationship and not that of independent contractor.
It was clear to the Tax Court that Dr. K, through his LLC, set up a plan to avoid having to pay IRS and state employment and withholding taxes.
Once the Court concluded that an employer-employee relationship existed, it was all downhill for poor Dr. K. The LLC will be responsible for back payroll taxes. In addition to this economic disaster, Dr. K himself will be exposed to the Trust Fund Recovery Penalty (TFRP) pursuant to IRC § 6672. Let’s not forget Arizona. The state is welcome to conduct a “me too” audit and assess substantial back employment and withholding taxes at the LLC level. This has now become the perfect storm of tax exposure.
In Part 3, I will discuss Dr. K’s argument that he should have been entitled to a safe harbor relief that would make him exempt from having to pay taxes.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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